Tuesday, March 12, 2013

Under my skin

Stiglitz and Weiss (1981) provide a basic rationale for the presence of such credit rationing. While basic economic theory suggests that in equilibrium prices adjust so that supply equals demand and no rationing arises, they show that this will not occur in the credit market due to the endogeneity of the quality of the loan. There are two key frictions that stand behind rationing: moral hazard and adverse selection. ...if a borrower has the ability to divert resources at the expense of the creditor, then creditors will be reluctant to lend to borrowers. Hence, for credit to flow efficiently from the creditor to the borrower, it is crucial that the borrower maintains ‘skin in the game’, i.e., that he has enough at stake in the success of the project, and so does not have a strong incentive to divert resources. This creates a limit on credit, and it can be amplified when economic conditions worsen, leading to a crisis.

Such forces were clearly working in recent years. The credit freeze following the financial meltdown of 2008, and the credit flow freeze in the interbank markets are both manifestations of the amplification of economic shocks due to the frictions in credit provision.

Not mentioned is that it was the regulators of banks (under pressure from 'community organizations') who created the ability of borrowers to have 'the ability to divert resources at the expense of the creditor'. Absent the interference by the federal government in the markets for home lending it wouldn't have happened. Which would suggest that there would have been no financial crisis, and no Great Recession.